mb0045 solved fall drive assignment 2011

8/3/2019 MB0045 Solved Fall Drive Assignment 2011

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Q1. What are the 4 finance decisions taken by a finance manager.

Ans. A firm performs finance functions simultaneously and continuously in the normalcourse of the business. They do not necessarily occur in a sequence. Financefunctions call for skilful planning, control and execution of a firms activities.

Let us note at the outset hat shareholders are made better off by a financialdecision that increases the value of their shares, Thus while performing thefinance function, the financial manager should strive to maximize the marketvalue of shares. Whatever decision does a manger takes need to result inwealth maximization of a shareholder.

Investment Decision

Investment decision or capital budgeting involves the decision of allocation ofcapital or commitment of funds to long-term assets that would yield benefits inthe future. Two important aspects of the investment decision are:

(a) the evaluation of the prospective profitability of new investments, and(b) the measurement of a cut-off rate against that the prospective return of newinvestments could be compared. Future benefits of investments are difficult tomeasure and cannot be predicted with certainty. Because of the uncertain future,investment decisions involve risk. Investment proposals should, therefore, beevaluated in terms of both expected return and risk. Besides the decision forinvestment managers do see where to commit funds when an asset becomes lessproductive or non-profitable.

There is a broad agreement that the correct cut-off rate is the required rate ofreturn or the opportunity cost of capital. However, there are problems in

computing the opportunity cost of capital in practice from the available data andinformation. A decision maker should be aware of capital in practice from theavailable data and information. A decision maker should be aware of theseproblems.

Financing Decision

Financing decision is the second important function to be performed by thefinancial manager. Broadly, her or she must decide when, where and how toacquire funds to meet the firms investment needs. The central issue before himor her is to determine the proportion of equity and debt. The mix of debt and

equity is known as the firms capital structure. The financial manager must striveto obtain the best financing mix or the optimum capital structure for his or herfirm. The firms capital structure is considered to be optimum when the marketvalue of shares is maximized. The use of debt affects the return and risk ofshareholders; it may increase the return on equity funds but it always increasesrisk. A proper balance will have to be struck between return and risk. When theshareholders return is maximized with minimum risk, the market value per sharewill be maximized and the firms capital structure would be considered optimum.


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Once the financial manager is able to determine the best combination of debt andequity, he or she must raise the appropriate amount through the best availablesources. In practice, a firm considers many other factors such as control, flexibilityloan convenience, legal aspects etc. in deciding its capital structure.

Dividend Decision

Dividend decision is the third major financial decision. The financial manager mustdecide whether the firm should distribute all profits, or retain them, or distributea portion and retain the balance. Like the debt policy, the dividend policy should be determined in terms of its impact on the shareholders value. The optimumdividend policy is one that maximizes the market value of the firms shares. Thusif shareholders are not indifferent to the firms dividend policy, the financialmanager must determine the optimum dividend payout ratio. The payout ratio isequal to the percentage of dividends to earnings available to shareholders. Thefinancial manager should also consider the questions of dividend stability, bonus

shares and cash dividends in practice. Most profitable companies pay cashdividends regularly. Periodically, additional shares, called bonus share (or stockdividend), are also issued to the existing shareholders in addition to the cashdividend.

Liquidity Decision

Current assets management that affects a firms liquidity is yet another importantfinances function, in addition to the management of long-term assets. Current assetsshould be managed efficiently for safeguarding the firm against the dangers ofilliquidity and insolvency. Investment in current assets affects the firms profitability.

Liquidity and risk. A conflict exists between profitability and liquidity while managingcurrent assets. If the firm does not invest sufficient funds in current assets, it may become illiquid. But it would lose profitability, as idle current assets would not earnanything. Thus, a proper trade-off must be achieved between profitability andliquidity. In order to ensure that neither insufficient nor unnecessary funds areinvested in current assets, the financial manager should develop sound techniques ofmanaging current assets. He or she should estimate firms needs for current assets andmake sure that funds would be made available when needed.It would thus be clear that financial decisions directly concern the firms decision toacquire or dispose off assets and require commitment or recommitment of funds on acontinuous basis. It is in this context that finance functions are said to influence production, marketing and other functions of the firm. This, in consequence, financefunctions may affect the size, growth, profitability and risk of the firm, andultimately, the value of the firm. To quote Ezra SolomonThe function of financial management is to review and control decisions to commit orrecommit funds to new or ongoing uses. Thus, in addition to raising funds, financialmanagement is directly concerned with production, marketing and other functions,within an enterprise whenever decisions are about the acquisition or distribution ofassets.


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Various financial functions are intimately connected with each other. For instance,decision pertaining to the proportion in which fixed assets and current assets aremixed determines the risk complexion of the firm. Costs of various methods offinancing are affected by this risk. Likewise, dividend decisions influence financingdecisions and are themselves influenced by investment decisions.

In view of this, finance manager is expected to call upon the expertise of otherfunctional managers of the firm particularly in regard to investment of funds.Decisions pertaining to kinds of fixed assets to be acquired for the firm, level ofinventories to be kept in hand, type of customers to be granted credit facilities,terms of credit should be made after consulting production and marketingexecutives.However, in the management of income finance manager has to act on his own.The determination of dividend policies is almost exclusively a finance function. Afinance manager has a final say in decisions on dividends than in assetmanagement decisions.

Financial management is looked on as cutting across functional even disciplinary boundaries. It is in such an environment that finance manager works as a part oftotal management. In principle, a finance manager is held responsible to handle allsuch problem: that involve money matters. But in actual practice, as noted above,he has to call on the expertise of those in other functional areas to discharge hisresponsibilities effectively.

Q.2 What are the factors that affect the financial plan of a company?

Ans. To help your organization succeed, you should develop a plan that needs to be followed.

This applies to starting the company, developing new product, creating a new department or anyundertaking that affects the companys future. There are several factors that affect planning in anorganization. To create an efficient plan, you need to understand the factors involved in theplanning process.

A businessman an businesswoman having a meeting image by sumos from Fotolia.com

A businessman an businesswoman having a meeting image by sumos from Fotolia.com

Organizational planning is affected by many factors.

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y Priorities

In most companies, the priority is generating revenue, and this priority can sometimes interferewith the planning process of any project. For example, if you are in the process of planning alarge expansion project and your largest customer suddenly threatens to take their business toyour competitor, then you might have to shelve the expansion planning until the customer issue


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is resolved. When you start the planning process for any project, you need to assign each of theissues facing the company a priority rating. That priority rating will determine what issues willsidetrack you from the planning of your project, and which issues can wait until the process iscomplete.

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ompany Resources

Having an idea and developing a plan for your company can help your company to grow andsucceed, but if the company does not have the resources to make the plan come together, it canstall progress. One of the first steps to any planning process should be an evaluation of theresources necessary to complete the project, compared to the resources the company hasavailable. Some of the resources to consider are finances, personnel, space requirements, accessto materials and vendor relationships.

y Forecasting

A company constantly should be forecasting to help prepare for changes in the marketplace.Forecasting sales revenues, materials costs, personnel costs and overhead costs can help acompany plan for upcoming projects. Without accurate forecasting, it can be difficult to tell ifthe plan has any chance of success, if the company has the capabilities to pull off the plan and ifthe plan will help to strengthen the companys standing within the industry. For example, if yourforecasting for the cost of goods has changed due to a sudden increase in material costs, then thatcan affect elements of your product roll-out plan, including projected profit and the long-termcommitment you might need to make to a supplier to try to get the lowest price possible.

y Contingency Planning

To successfully plan, an organization needs to have a contingency plan in place. If the companyhas decided to pursue a new product line, there needs to be a part of the plan that addresses thepossibility that the product line will fail. The reallocation of company resources, the acceptablefinancial losses and the potential public relations problems that a failed product can cause allneed to be part of the organizational planning process from the beginning

Q.3 Show the relationship between required rate of return and coupon rate on the value of

a bond.

Ans. It is important for prospective bond buyers to know how to determine the price of a bondbecause it will indicate the yield received should the bond be purchased. In this section, we will

run through some bond price calculations for various types of bond instruments.

Bonds can be priced at a premium, discount, or at par. If the bonds price is higher than its parvalue, it will sell at a premium because its interest rate is higher than current prevailing rates. Ifthe bonds price is lower than its par value, the bond will sell at a discount because its interestrate is lower than current prevailing interest rates. When you calculate the price of a bond, youare calculating the maximum price you would want to pay for the bond, given the bonds couponrate in comparison to the average rate most investors are currently receiving in the bond market.


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Required yield or required rate of return is the interest rate that a security needs to offer in orderto encourage investors to purchase it. Usually the required yield on a bond is equal to or greaterthan the current prevailing interest rates.

Fundamentally, however, the price of a bond is the sum of the present values of all expected

coupon payments plus the present value of the par value at maturity. Calculating bond price issimple: all we are doing is discounting the known future cash flows. Remember that tocalculate present value (PV) which is based on the assumption that each payment is re-investedat some interest rate once it is receivedwe have to know the interest rate that would earn us aknown future value. For bond pricing, this interest rate is the required yield. (If the concepts of present and future value are new to you or you are unfamiliar with the calculations, refer toUnderstanding the Time Value of Money.)

Here is the formula for calculating a bonds price, which uses the basic present value (PV)formula:

C = coupon paymentn = number of paymentsi = interest rate, or required yieldM = value at maturity, or par value

The succession of coupon payments to be received in the future is referred to as an ordinaryannuity, which is a series of fixed payments at set intervals over a fixed period of time. (Couponson a straight bond are paid at ordinary annuity.) The first payment of an ordinary annuity occursone interval from the time at which the debt security is acquired. The calculation assumes this

time is the present.

You may have guessed that the bond pricing formula shown above may be tedious to calculate,as it requires adding the present value of each future coupon payment. Because these paymentsare paid at an ordinary annuity, however, we can use the shorter PV-of-ordinary-annuity formulathat is mathematically equivalent to the summation of all the PVs of future cash flows. This PV-of-ordinary-annuity formula replaces the need to add all the present values of the future coupon.The following diagram illustrates how present value is calculated for an ordinary annuity:

Each full moneybag on the top right represents the fixed coupon payments (future value)

received in periods one, two and three. Notice how the present value decreases for those couponpayments that are further into the future the present value of the second coupon payment is worthless than the first coupon and the third coupon is worth the lowest amount today. The farther intothe future a payment is to be received, the less it is worth today is the fundamental concept forwhich the PV-of-ordinary-annuity formula accounts. It calculates the sum of the present valuesof all future cash flows, but unlike the bond-pricing formula we saw earlier, it doesntrequire that we add the value of each coupon payment. (For more on calculating the time value


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Notice that the only modification to the original formula is the addition of F, which representsthe frequency of coupon payments, or the number of times a year the coupon is paid. Therefore,for bonds paying annual coupons, F would have a value of one. Should a bond pay quarterlypayments, F would equal four, and if the bond paid semi-annual coupons, F would be two.

Q.4 Discuss the implication of financial leverage for a firm.

Ans. The financial leverage implies the employment of source of funds, involving fixed returnso as to cause more than a proportionate change in earnings per share (EPS) due to change inoperating profits. Like the operating leverage, financial leverage can be positive when operatingprofits are increasing and can be negative in the situation of decrease in such profits. In view ofthese, financial leverage will affect the financial risk of the firm. An important analytical tool for

financial leverage is the indifference point at which the EPS/market price is the same fordifferent financial plans under consideration.

The objective of this study was to provide additional evidence on the relationship betweenfinancial leverage and the market value of common stock. Numerous empirical studies have beendone in this area, and, concurrently, many theories have been developed to explain therelationship between financial leverage and the market value of common stock. Because of themethodological weaknesses of past studies, however, no conclusions can be drawn as to thevalidity of the theories. Theories on financial leverage may be classified into three categories:irrelevance theorem, rising from value indefinitely with increase in financial leverage, andoptimal financial leverage. Empirical implications of these categories along with the

consequences of serious confounding effects are analyzed. The implications are then comparedwith evidence from actual events involving financial leverage changes, and distinguished fromeach other as finely as possible, using simple and multiple regression analyses, normal Z-test,and a simulation technique. The evidence shows that changes in the market value of commonstock are positively related to changes in financial leverage for some firms and negatively relatedfor other firms. This evidence is consistent with the existence of an optimal financial leverage foreach firm, assuming that financial leverages of firms with a positive relationship are below theoptimum and those of firms with a negative relationship are above the optimum. The results ofthe study do not depend upon the definition of the market portfolio, the definition of the event period, or the choice of financial leverage measure. Betas estimated from equally weightedmarket portfolios were generally higher than those estimated from value weighted marketportfolios during 1981-1982. However, the results of the study were the same for both portfolios.Abnormal returns were computed for seven and two day event periods, and the results were thesame for both periods. Seven different definitions of financial leverage were tested, and theresults were the same for all measures.

Q.5 The cash flows associated with a project are given below:Year Cash flow0 (100,000)1 25000


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2 400003 500004 400005 30000Calculate the a) payback period.b) Benefit cost ratio for 10% cost of capital

a)

.:-From the cumulative cash flows column. A recover the initial cash out tag ofRs. 1000,00 at theend of the third year. Therefore payback period of project is 2 years.Therefore payback period

= 2 + 100000-6500050000

= 2 + 3500050000

= 2.7 years

Solution:

b). Benefit cost ratio for 10% cost of capital.

= 3 + 100000-9331527320


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= 3 + 668527320

= 3 + .244= 3.244

Q6. A companys earnings and dividends are growing at the rate of 18% pa. The growth rate isexpected to continue for 4 years. After 4 years, from year 5 onwards, the growth rate will be 6%forever. If the dividend per share last year was Rs. 2 and the investors required rate of return is10% pa, what is the intrinsic price per share or the worth of one share.

mb0045 solved fall drive assignment 2011

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